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WORKING PAPER
ALFRED P. SLOAN SCHOOL OF MANAGEMENT



The Treasury Bill Auction and the When-Issued

Market: Some Evidence

by

Sushil Bikhchandani and Chi-fii Huang

WP #3467-92 September 1992



MASSACHUSETTS

INSTITUTE OF TECHNOLOGY

50 MEMORIAL DRIVE

CAMBRIDGE, MASSACHUSETTS 02139



The Treasury Bill Auction and the When-Issued

Market: Some Evidence

by

Sushil Bikhchandani and Chi-fu Huang

WP #3467-92 September 1992



T 2 1992:.



The Treasury Bill Auction and the When-Issued
Market: Some Evidence*

Sushil Bikhchandani^ and Chi-fu Huang^
September 1992



Abstract

We empirically examine the link between the when-issued market and the auction for Trea-
sury bills. We find that on average it is cheaper to buy Tresisury bills in the auction than in the
when-issued market just before the auction closes. Surprisingly, primary dealers often submit
bids in the auction that are higher in price than the concurrent when-issued ask price. We
present evidence to show that this is related to information costs of trading in the when-issued
market before the auction. Several hypotheses suggested by economic theory are also tested.



' We thank Darrell Duffie, John Heaton, Andrew Lo, Sunil Sharma, Paul Spindt, Jiang Wang, and seminar par-
ticipants at the Federal Reserve Bank of Atlanta, Stanford University, and the University of California at Berkeley
for helpful discussions and comments, Elaine Lai, Elaine Robbins, and Gretchen Schroeder for data collection, and
Chaiyot Chanyam and Jie Wu for computation assistance. We are specially grateful to Chiang Sung (formerly of
Shearson Lehman and now of Grand Cathay Securities Corp. of Taiwan), who for three years answered our weekly
calls for when-issued prices and our numerous questions regarding the when-issued markets, and to David Schwartz
(of Mitsubishi Capital Market Services in New York), who helped us obtain the daily when-issued prices at 3:30
pm. Partial financial support from the MidAmerica Institute and from the International Financial Services Research
Center of MIT is gratefully acknowledged. The usual disclaimer applies.

' Anderson Graduate School of Management, University of California, Los Angeles, CA 90024.
' Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02139.



1 INTRODUCTION AND SUMMARY



1 Introduction and Summary

A huge volume of U.S. Treasury bills, notes, and bonds are traded daily by many buyers and
sellers. Therefore it may seem rejisonable to think of the U.S. Treasury securities market as per-
fectly competitive. However, recent alleged infractions by Salomon Brothers suggest that such an
assumption may be inaccurate. Noncompetitive behavior in the U.S. Treasury securities market
can significantly increase the cost of government debt financing. In addition, default-free interest
rates determined in these markets serve as a benchmark for the valuation of other risky securities
such as common stocks and corporate bonds.

Consequently, these alleged abuses have prompted a review of the Treasury securities market.^
At the same time these violations reveal how little is known about the market for Treasury securities.
This is in part because data are not readily available to researchers as these markets are over-the-
counter. Although some auction data is announced by the Department of Trecisury, information on
forward contracts for Treasury securities is difficult to obtain. We have gathered data on forward
contract prices by calling a dealer over a three year period. We use this data to examine the link
between the forward market and the auction for Treasury bills.

The U.S. Treasury securities market offers an interesting opportunity to study the price forma-
tion process. There are two different markets that exist simultaneously: (i) U.S. Treasury securities
are sold at auctions, and (ii) forward contracts on the Treasury securities can be bought and sold for
delivery "when-issued." The forward market, which is called the when-issued market, is a double
auction.^ By comparing the prices in these two markets, we can learn how the orgcinization of
markets affects prices. The when-issued market opens before the auction and remains open during
and after the auction. Before the auction, the when-issued market could aggregate the possibly
diverse information of participants in this market, and thus have an impact on the auction. Further,
the movement of prices in the when-issued market after the auction and before the announcement
of the auction results can be an indication of how efficiently the when-issued market reflects the
information innovation contained in the auction. A bidder may trade in the two markets in a
manner that best protects her private information. If so, one might be able to detect this behavior
by comparing prices across markets.

We empirically examine the relation between the when-issued mcirket and the weekly auction



See, for example, the Joint Report on the Government Securities Market (1992).

^A double auction is an auction where bidders can be buyers or sellers; see Wilson (1985) and Hindy (1990). A
single auction, such as a Treasury securities auction, is one in which ail the bidders are buyers and the auctioneer is
the only seller.



1 INTRODUCTION AND SUMMARY 2

for 13 week and 26 week Treasury bills. Several hypotheses suggested by economic theory are tested
and shown to be broadly consistent with the data. In particular, we present evidence of strategic
interplay between the when-issued market and the auction. The data suggest that traders in the
when-issued market take into account the possibility that the when-issued prices might reveal, at
least partially, their private information. If traders with large demands trade mainly in the auction
instead of the when-issued market, their private information is revealed only after the auction is
over. Thus auction prices are expected to be more informative than when-issued prices at the
auction time.

Cammack (1991) and Spindt and Stolz (1991), investigate the relation between auction prices for
13 week Treasury bills and prices of seasoned Treasury bills that have the same time to maturity
as the newly auctioned bills. They find systematic underpricing in the auction, Cammack by 4
basis points and Spindt and Stolz by 7 basis points. Their results, however, are colored by two
factors. First, the seasoned bills are usually traded at a (price) discount relative to their on-the-run
counterparts.'' This by itself would not change their conclusion of underpricing in the auctions, but
would certainly change the magnitude of underpricing. Second, seasoned Treasury securities are
quoted for a different delivery date than the delivery date of the newly auctioned bills.'' For proper
comparison, the secondary market prices for the seasoned securities have to be adjusted. This
adjustment, done using the Federeil funds rate by Cammack Jind by Spindt and Stolz, introduces
mecLSurement errors into their calculations. In contrast, we compcire when-issued prices at the
auction time with the winning prices in the auction. Both the auction and the when-issued market
on the day of the auction are markets for forward contracts (on Treasury biUs) with three days
to maturity. No adjustment is needed to make the comparison and no measurement errors are
introduced.

Other related papers include Cornell and Shapiro (1989), who document an apparent anomaly
in the pricing of 30 year Treasury bonds, and Jegadeesh (1992), who estimates the profit primary
dealers can make by buying Treasury notes and bonds in the auction and selling in the secondary
market.^ Cornell (1992) examines whether the bid-ask spread on Treasury securities increases dur-
ing a short squeeze. Related theoretical work includes Wilson (1979), Milgrom and Weber (1982),
Bikhchandani and Huang (1989, 1992), Back and Zender (1992), and Duffie (1992).



The newly auctioned Treasury securities are said to be on-the-run.

^Starting {rem the afternoon of the auction day, which is usually a Monday, on-the-run bills are quoted for delivery
the coming Thursday when the newly auctioned bills are delivered. Cammack uses a sample of quotes for seasoned
bills that are delivered two business days later. Spindt and Stolz use a sample of quotes that are delivered the next
business day. Currently, except for on-the-run bills. Treasury bills are quoted for delivery on the next business day.

*The total profit made by primary dealers is impossible to estimate using publicly available data. A dealer can
take a short position in the when-issue market and buy at the auction. The profit made may not depend on the
secondary market price.



2 INSTITUTIONAL DETAILS OF THE TREASURY BILL MARKET 3

The rest of this paper is organized as follows. We describe, in Section 2, the institutional
structure of the when-issued market and the auction for Treasury bills. In Section 3 we describe
the data and in Section 4 we discuss some summary statistics. We find that on average it was
about 2 bcLsis points cheaper to buy 13 week bills in the auction than in the when-issued market.^
For 26 week bills the auction was cheaper by about 1 basis point. We also find that about 80% of
the time for 13 week bills cind 77% of the time for 26 week bills, bids were submitted in the auction
that were higher in price than the when-issued ask price at the auction time. This indicates the
existence of information costs of trading in the when-issued markets.

In Section 5 we examine the relation between the auction and the when-issued market before
the auction. The evidence suggests that the when-issued market aggregates information effectively
in that lagged auctions do not convey information about the future auction, given the information
contained in the when-issued prices. However, when-issued price changes before the auction can
convey some information given the when-issued prices at auction time. We also show that the
dispersion of bids in the auction are positively related to the bid-ask spreads and the term premium
in the when-issued markets.

We investigate the link between post-auction price changes in the when-issued market and
the auction in Section 6. The change in when-issued prices on auction days, after the auction but
before the announcement of the auction results, is significantly related to the information innovation
contained in the auction. In addition, the information innovation contained in the auction and the
price change in the when-issued market after the auction are significantly related to whether there
are bids in the auction that are higher in price than the when-issued ask price at the auction time.
This is further confirmation of the strategic interaction between the auction and the when-issued
markets. We examine, in Section 7, whether there is any evidence of coUusion in Treasury bill
auctions. We do not reject the null hypothesis that during the sample period bidders in 13 week
bill and 26 week bill auctions did not collude. Section 8 contains concluding remarks.

2 Institutional Details of the Treasury Bill Market

Every week the Department of Treasury auctions 13 week and 26 week bills. The auction is held
every Monday and the deadline for competitive bids is 1:00 pm.*^ Currently, there are 38 competitive



^This contrasts with Cammack's finding that underpricing in the 13 week bills auction, compared to the corre-
sponding seasoned bills, was 4 basis points. Spindt and Stolz's figure for underpricing in the auction was 7 basis
points.

When Monday is a holiday, the auction is held on the first trading day after Monday.



2 INSTITUTIONAL DETAILS OF THE TREASURY BILL MARKET 4

bidders, called primary dealers, who submit sealed bids that are discount rate-quantity pairs. ^'^
Although primary dealers may submit as many discount rate-quantity bids as they wish, often each
primary dealer submits one or two bids only. The primary dealers buy Treasury bills for their
institutional clients and for resale on the secondary market. The noncompetitive bidders, mcunly
individual investors, submit sealed bids that specify quantity only (up to a maximum of 1 million
dollars). The noncompetitive bids, which usually account for 15-20% of the amount sold, always
win at a rate equal to the quantity weighted average of the winning competitive bids.

The competitive bidders compete for the remaining bills in a discriminatory auction. That is,
the demands of the bidders, starting with the lowest rate bidder up, are met until all the bills are
allocated. The winning competitive bidders pay the unit prices implied by the discount rates they
submitted. After the auction, the Department of Treasury announces summary statistics about
the bids submitted. These include total tender amount received, total tender amount accepted,
lowest winning rate (highest winning price), highest winning rate (lowest winning price), proportion
of bids accepted at the highest winning rate (lowest winning price),^° quantity weighted average
of winning rates, and the split between competitive and noncompetitive bids. Treasury bills are
delivered to the winning bidders on Thursday and can be resold in an active secondary market .^^

There is a forward market for Treasury bills. Every Tuesday the Treasury announces the amount
of bills to be auctioned the following Monday. The primary dealers begin trading, for themselves
and for their Institutional clients, forward contracts on the bills to be auctioned. ^'^ These forward
contracts are called when-issued. Their maturity date is the Thursday of the auction week, the
same day that the newly auctioned Treasury bills are delivered. After the auction, trading continues
in the when-issued market until the when-issued contracts mature, subsequent to which the bills
are traded in a secondary market. Thus there are two different markets for acquiring Treasury bills
around auction time — the Treasury auction and the when-issued market. The when-issued market
is a market with zero net supply and can be thought of as a double auction held continuously over
several days. The weekly auction of Treasury bills has a positive supply of bills and is held at a
single point in time.'"' The open interest in the when-issued market varies from a small amount to



'For a 13 week bill with a face value of 1000, a discount rate of 5.98%, say, translates into a price of 1000(1 —
5.98%(91/360)) = 985.09. The competitive bidders can only submit discount rates which are whole basis points. A
basis point is one hundredth of 1 percent.

°The Treasury stipulates that the sum of the amount of the bills won in the auction by a primary dealer and her
long position in the when-issued market cannot exceed 35% of the total amount auctioned. In addition, a primary
dealer cannot submit bids in an auction larger in quantity than the total amount auctioned.

That is, amount of bids accepted at the highest winning rate divided by the amount of bids received at this rate.
The Treasury bills are not physically delivered to the winning bidders. Rather, they are registered to the winning
bidders in book entry form; see Fabozzi and Pollack (1983).

A standard forward contract is for a principal amount of $5 million.
'''See Footnote 2.



2 INSTITUTIONAL DETAILS OF THE TREASURY BILL MARKET 5

several times the amount auctioned.

A primary dealer can acquire Treasury bills in three ways — buy in the when-issued market
before the auction, submit bids in the auction, or buy in the when-issued market or in the secondary
market after the auction. If a primary dealer buys in the when-issued market or the secondary
market she is sure to get the bills, whereas she faces the uncertainty of losing in the auction.
However, there is an advantage in buying in the auction. A primary dealer who has a large demand
for the bills to be auctioned, may reveal this information if she buys before the auction in the
when-issued market. This will increase the when-issued ask price and encourage aggressive bidding
in the auction. In contrast, if she bids in the auction this private information may be revealed only
after the auction.

Besides aggregating the participants' information, the when-issued market serves as a forward
market. Many primary dealers are short in the when-issued market before the auction as they sell
these contracts to those institutionaJ clients who want to be certain of obtaining the bills to be
auctioned. Of course, some institutional clients may also be short in the when-issued market. A
short squeeze occurs when many of those who are short in the when-issued market fail to acquire
bills in the auction. In this event, they have two alternatives. They can buy back in the when-
issued market after the auction or they can "borrow" the newly auctioned bills in the repurchase
and reverse markets, also known as "repo" and reverse markets.

The repo and reverse market is a market for short-term borrowing and lending that is collat-
eralized by securities.^'' If, for instance, an individual who possesses securities needs to borrow
funds overnight, he can "sell" the securities to a counter party and at the same time sign with her
an agreement to repurchase these securities the next day at a predetermined price. This predeter-
mined price may be equal to the selling price paid on the previous day by the counter party. In this
case, the counter party is paid an explicit repo rate on the money she invests. Alternatively, the
purchase price is set to be different from the selling price so that the counter party earns returns
due to her. In either case, the return earned by the counter party is called the "repo rate" for
the securities used as collateral. The counter party in a repo agreement is said to be engaged in
a "reverse repo" — borrowing securities while loaning out funds. When there is a short squeeze,
say in the when-issued for 13 week Treasury bills, the repo rate using the newly auctioned 13 week
Treasury bills as collateral might decrease dramatically and can even become negative. This is
because these bills become scarce commodities and one can borrow money cheaply using them as
collateral. These bills are said to be traded "special".



'*See Stigum (1989).



3 THE DATA 6

3 The Data

We have collected data for the period from February 24, 1986 to November 28, 1988. Although
145 auctions were held during this period, for 15 of these auctions we could not collect when-issued
price data at auction times. We have:

1. 130 observations of the bid and ask (discount) rates for 13 week and 26 week when-issued at
1:00 pra on auction days.^^

2. The average of bid and ask rates for 13 week and 26 week when-issued at 3:30 pm on auction
days and at 3:30 pm on Tuesday, Wednesday, Thursday, and Friday in the previous week.^^
During the sample period, the auction results were announced after 3:30 pm. Currently, the
auction results are announced at around 2:00 pm. The sample size for these observations are
as follows:





Tuesday


Wednesday


Thursday


Friday


Monday


13 Week
26 Week


144
144


144
144


140
140


137
137


131
131



3. Summary statistics of the 130 auctions that correspond to the when-issued rates at 1:00 pm
on auction days in our data set. These statistics include quantity weighted average winning
rate, lowest and highest winning rates, and proportion of bids accepted prorata at the highest
winning rate.

The daily 3:30 pm when-issued data are from Data Resources Inc., (DRI).^^ The when-issued
rates at 1:00 pm on auction days are not publicly avciilable. We collected this data in real time
by calling a dealer at Shearson Lehman at 1:00 pm on auction days.^* The summary statistics of
the weekly auction are announced by the Department of Treasury, and are published in The Wall
Street Journal}^



'^The when-issued is quoted by its discount rate as described in Footnote 8. The bid rate is the discount rate at
which one sells and the ask rate is the discount rate at which one buys.

The when-issued market begins on Tuesday in the week before bill is auctioned.
'^For 11 observations in our data set, the auctions were not held on Monday. We do not have the when-issued rates
for the newly auctioned bills at 3:30 pm on auction days for these data points. Thus variables CHG13 and CHG26
(defined in Table 1 below) were not available for these observations. However, we have the when-issued rates at 1:00
pm on the day of the auction for these bills. In calculations involving the when-issued rates at 1:00 pm, we did not
exclude those auctions that did not occur on a Monday.

We thank Chiang Sung for patiently answering our weekly calls for three years. We are also thankful to Elaine
Robbins and Gretchen Schroeder who dutifully called Chiang Sung on our behalf to collect these data.
We thank Elaine Lai for collecting this data.



4 DATA SUMMARY 7

4 Data Summary

Table 1 (all tables are in Section 10) lists definitions of the variables we use. To facilitate comparison
between 13 week bills and 26 week bills, we represent the data in (discount) rates rather than prices.
Sample statistics are shown in Table 2. We first focus on 13 week Treasury bills. On average, the
highest winning rate was 1 basis point higher than the (quantity weighted) average winning rate
and 4 basis points higher than the lowest winning rate.'^^ The average bid-ask spread of the quotes
of the when-issued at 1:00 pm on auction days was 1 basis point. On average, it was 2 basis points
cheaper to buy 13 week bills in the auction at the average winning rate than in the when-issued
market at 1:00 pm on auctions days, i.e., one earns a 0.02% higher interest rate at the average
winning auction rate than at the when-issued ask rate. If one could win the auction at the highest
winning rate, then it would be about 3 basis points cheaper to buy 13 week bills in the auction
than in the when-issued market.

Recall that there are three ways to acquire Treasury bills: buy in the when-issued market before
the auction, submit bids in the auction, or buy in the when-issued market or the secondary market
after the auction.^' If one buys in the when-issued market before the auction, one can be sure
of getting the new bills, while one is uncertain about winning in the auction. We believe that on
average the when-issued ask rate at 1:00 pm on auction days is lower than the average winning rate
in the auction to compensate for the risk of not winning at the auction.

Somewhat surprisingly, the when-issued ask rate at 1:00 pm on auction days was on average
1.5 basis points higher than the lowest winning rate in the auction, with the maximum difference
being 8.5 basis points. In 104 out of 130 auctions, i.e., 80% of the time, there was at least one
bidder who submitted in the auction a rate lower (a price higher) than the concurrent when-issued
ask rate (price).

An explanation of this apparent anomaly may be the cost to a primary dealer of revealing her
private information before the auction. If a primary dealer buys a large amount in the when-issued
market prior to the auction she may influence the when-issued rates and thereby convey information
to competing bidders about her high demand. This will make others bid more aggressively in the
auction and reduce this primary dealer's probability of winning, ceteris paribus. In contrast, if she
submits a bid at a low rate in the auction she will almost certainly win. Other bidders will learn
about her high demand only upon announcement of auction results a few hours after the auction.
Thus observing a lower bid rate in the auction than the when-issued ask rate may be an indication



Recall from Footnote 8 that 1 basis point is one-hundredth of 1 percent.
^'The newly auctioned bills are delivered on the Thursday following the auction. Before their delivery, these bills
continue to be traded in the when-issued market also for Thursday delivery. After their delivery, these bills are traded
in the secondary market for second day delivery.



4 DATA SUMMARY 8

of the strategic interplay between the when-issued market and the auction. We present a detailed
analysis in Section 6.

The when-issued bid rate at 1:00 pm was on average 0.8 basis points lower than the average
winning rate at the auction and was lower than the highest winning rate by 1.8 basis points.
This suggests the possibility of selling the when-issued just before the auction and buying back
at the auction to make a profit. However, one faces the risk of losing at the auction and being


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Online LibrarySushil BikhchandaniThe Treasury bill auction and the when-issued market : some evidence → online text (page 1 of 4)